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Gross Margin

Guide to Understanding the Gross Margin

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Gross Margin

How to Calculate Gross Margin

Calculating a company’s gross margin involves dividing its gross profit by the revenue in the matching period, which are both metrics found on the GAAP-based income statement.

The gross profit margin answers the following question:

  • “How much in gross profits is kept for each dollar of revenue?”

The gross profit metric represents the remaining revenue after subtracting direct costs (COGS), with direct costs referring to expenses directly tied to the production and delivery of specific goods and/or services (typically variable costs).

The COGS are matched to the associated revenues in the same time period, which is commonly known as the “matching principle” of accounting. Examples of COGS include the following:

  • Direct Labor Costs
  • Purchase of Materials (i.e. Inventory)

The calculation process is as follows:

  • Step 1: First, we must take the net revenue and the cost of goods sold (COGS) figures from the income statement.
  • Step 2: Next, we’ll calculate the gross profit by subtracting COGS from revenue.
  • Step 3: Lastly, we’ll divide the gross profit of each company by the amount of revenue in the corresponding period to quantify the gross profit margin.

Gross Margin Formula

The formula to calculate the gross profit margin is as follows.

Formula
  • Gross Profit Margin = Gross Profit / Revenue

In order to express the metric in percentage form, the resulting decimal value figure must be multiplied by 100.

For example, if a company has generated $10 million in revenue with $3 million in COGS, the gross profit is $7 million.

Upon dividing the $7 million in gross profit by the $10 million in revenue and then multiplying by 100, we arrive at 70% as our GM %. Based on the 70% GM, we can gather that the company has earned $0.70 in gross profit for each $1.00 of revenue.

How to Interpret the Gross Profit Margin

Interpreting a company’s gross margin as either “good” or “bad” depends substantially on the industry in which the company operates. For any comparisons to be useful, the companies must operate in the same or similar industry with available historical data dating back several years to get a better sense of the industry norm (and patterns).

For example, software companies have been known for having high gross margins, while clothing retailers have historically exhibited razor-thin gross margins and rely on volume to remain profitable.

Service-based industries also tend to have higher gross margins since the COGS for such businesses are minimal (e.g. consulting firms), whereas capital-intensive companies (e.g. manufacturing, industrials, retail) normally have lower gross margins due to margin erosion from the direct costs related to building up inventory, manufacturing products, etc.

Nevertheless, industries with significant direct costs can still consist of market leaders with consistent profits that retain meaningful market shares (e.g. airlines, transportation, retail).

Higher gross margins are usually viewed in a positive light, as the potential for higher operating margins and net profit margins increases. An accurate assessment of the gross profit metric depends, however, on understanding the industry dynamics and the company’s current business model.

A couple of common methods for companies to increase their gross margin are the following:

  1. Increase Average Selling Price (ASP) – Requires Pricing Power, Upselling, etc.
  2. Purchase Inventory at Lower Prices – Requires Negotiating Leverage with Suppliers (e.g. High Order Volume/Frequency, Bulk Purchases, Branding)
  3. Integrate Higher Margin Products/Services – Adding New Products/Services with Higher Gross Margins Could Lead to Improved Customer Retention and Cross-Selling Opportunities
Apple (AAPL) Income Statement Example

Apple’s gross profit line item is highlighted in the screenshot below.

AAPL Gross ProfitApple Gross Profit (Source: WSP Financial Statement Modeling)

Gross Margin vs. Net Profit Margin

The gross profit margin only accounts for direct costs (i.e. COGS), while the net profit margin accounts for all expenses, including operating expenses and non-operating expenses.

The fact that net income is “levered” (i.e. post-debt) and flows solely to equity holders is one of the primary drawbacks to the net margin metric.

In contrast, the gross profit margin accounts for just one outflow of cash, which is the direct costs associated with the production of revenue.

The gross profit margin, unlike the net margin, is largely unaffected by financing decisions or discretionary accounting policies such as useful life assumptions for purchases of PP&E or differences in the tax rate, making it better suited for peer comparisons since there is a far lower potential for manipulation via discretionary accounting decisions by management.

Gross Margin Calculator – Excel Model Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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Gross Margin Calculation Example

For our example modeling exercise, we’ll be calculating and comparing the gross profit margin of three companies, with each having different revenue and COGS assumptions.

To begin, we’ll start by listing out the revenue and cost of goods sold (COGS) assumptions for each company.

Income Statement – Company A

  • Revenue = $200m
  • Cost of Goods Sold (COGS) = –$80m

Income Statement – Company B

  • Revenue = $200m
  • Cost of Goods Sold (COGS) = –$60m

Income Statement – Company C

  • Revenue = $200m
  • Cost of Goods Sold (COGS) = –$100m

Using these figures, we can calculate the gross profit for each company by subtracting COGS from revenue.

  • Gross Profit:
    • GP, Company A: $200m – $80m = $120m
    • GP, Company B: $200m – $60m = $140m
    • GP, Company C: $200m – $100m = $100m

Next, the gross profit would be divided by revenue to get the gross margin.

  • Gross Margin:
    • GM %, Company A: $200m ÷ $120m = 60.0%
    • GM %, Company B: $200m ÷ $140m = 70.0%
    • GM %, Company C: $200m ÷ $100m = 50.0%

Despite the differences in operating expenses (OpEx), interest expenses, and tax rates among these companies, none of these differences are captured in the gross margin.

The gross margin isolates the profits only after COGS is factored in, which makes the metric more informative for peer group comparisons.

Since COGS were already taken into account, the remaining funds are available to be used to pay operating expenses (OpEx), interest expenses, and taxes.

For instance, the operating profit margin, which accounts for COGS and OpEx, is 20% for Company A, 35% for Company B, and 5% for Company C.

As in the case of all profitability metrics, the gross margin should be used in conjunction with other metrics to fully understand the cost structure and business model of the company.

Gross Margin Calculator

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